Post on 29-Jun-2021
Tiered DiscountsTiered Discounts in Theory and PracticeMonograph SummaryMonograph Summary
2015 ABA ConferencePalm Desert CaliforniaPalm Desert, CaliforniaApril 30, 2015William C. Herber, CBA, CVAShenehon Company
www.shenehon.com
2
Appraisal Wisdompp
Value is in the eye of the beholder.– American Management GuruAmerican Management Guru
www.shenehon.com
3
For every complex problem, th i i l l tithere is a simple solution that is wrong.
– George Bernard Shawg
www.shenehon.com
4
What are tiered (or layered) ( y )discounts?There are “multi-tiered entities and businessesThere are multi-tiered entities and businesses inside of a business. Valuation theory permits separate discounts for lack of control and
k t bilit t h hi l l t tmarketability at each ownership level to account for the incremental risk to which each new level exposes investors.”p- Ciro V. Cuono, CPA/ABV/CFF, CVA, LGM-A
www.shenehon.com
5
IntroductionIntroduction
WHAT IS THE IMPACT OF TIERED DISCOUNTS ON VALUE?DISCOUNTS ON VALUE?The use (or lack thereof) of Tiered (stacked, layered) Discounts significantly impacts thelayered) Discounts significantly impacts the appraisal conclusion. Many appraisers do not fully comprehend the impact of such discounts, how to calculate them or when to apply themhow to calculate them, or when to apply them.
www.shenehon.com
6
Example of Layered DiscountsExample of Layered Discounts
www.shenehon.com
7
Example of Layered Discountsp y
www.shenehon.com
8
IntroductionAppropriateness of the application of two or more levels of discounts:more levels of discounts:Frequently, the taxpayer (client) holds a minority interest in one entity which, in turn, holds a minority interest in another entity. To accurately value a minority interest of this nature, the appraiser may decide it is appropriate to apply a app a se ay dec de t s app op ate to app y adiscount for lack of marketability and/or a discount for lack of control at two (or more) levels
www.shenehon.com
levels.
9
IntroductionDiscount at the first level, then take additional discount at the second level:additional discount at the second level:In order to arrive at the value of the subject minority interest, the appraiser discounts value b d th t ’ i t t i th i i lbased on the taxpayer’s interest in the original entity (tier one). Subsequently, the appraiser discounts value a second time (tier two) to ( )account for the additional lack of control and/or a lack of marketability which is a direct result of the subject entity being held by a second entity
www.shenehon.com
subject entity being held by a second entity.
10
Introduction - Are we leaping too far? Maybe, maybe not. It depends on the facts.depends on the facts.The process is repeated at each level of ownership reducing the net asset value little byownership, reducing the net asset value little by little at each step.
www.shenehon.com
11
IntroductionIntroductionCan we all agree that when we value a real
t t ti t hi th d lt iestate operating partnership, the end result is on a CASH basis?
www.shenehon.com
12
ABC Business Group (Second Level of Discounts)
S A tl f d M
JEWEL Partners (Pass Through, No Discounts)
See Astleford. May or may not have a business purpose.
XYZ Entity (Non‐controlling Interests in Multiple Underlying Real Estate Holding Entities) (First Level of Discounts‐Traditional)
= Additional restrictions due to agreements, ownership structure, distributions and debt drive the additional discounts
= Limited restrictions (not material enough to require discounts)/Limited, if any, business purpose (pass‐through entity)
= Basic non‐controlling (minority) and lack of marketability discount analysis
The above graphic summarizes the non-controlling interests illustrated in the flow chart on the following page. It is the non-controlling interests that are the subject interests being valued.
Basic non controlling (minority) and lack of marketability discount analysis
www.shenehon.com
interests that are the subject interests being valued.
13
Impact on ValueHow does using tiered discounts impact the appraisal conclusion? H d d t i th t ti fHow do we determine the next tier of discounts?
• When dealing with tiered or layered discounts in an entity or partnership structure, the most important question is: How much additionalimportant question is: How much additional discount for lack of control and/or lack of marketability should the appraiser take at the
d l l?
www.shenehon.com
second level?
14
Specialized KnowledgeWhy does specialized knowledge improve the credibility of the appraisal outcome?outcome?
• Value Concepts• DatabasesDatabases• Experienced appraisers rely on information from a
variety of knowledge bases to corroborate and verify the value concepts addressed in the given appraisalthe value concepts addressed in the given appraisal assignment. What databases are the most appropriate for different tiered or layered discounts?
www.shenehon.com
15
Specialized Knowledgep g• Closed End Equity Funds: the appraiser must
have an in-depth understanding of how closed end funds work and how the discounts are derived.
• Asset Classes: it is critical for the appraiser to recognize the nature and risk of the asset class being discounted Familiarity with annual yieldbeing discounted. Familiarity with annual yield and appreciation for the various asset classes is also essential.
www.shenehon.com
16
Specialized Knowledgep g• Management: the appraiser must understand
the impact management has on a company’s performance. For some companies, little to virtually no management is needed.
• Agreements: the appraiser should carefully review and consider the terms of the entity agreement(s) and the ownership structure inagreement(s) and the ownership structure in place (governance).
www.shenehon.com
17
Specialized Knowledgep g• Relevant Court Cases: a comprehensive study of
decisions dealing with tiered or layered discounts will reveal key issues for the appraiser to address in the reportreveal key issues for the appraiser to address in the report.
• Estate of Astleford (see next slide)• Estate of Dean: liquidation rejected – NAV accepted – two
ti f di t t dtiers of discounts accepted• Estate of Gallun: no discount for capital gain on the
assumption of liquidation – court did allow two tiers of di tdiscounts
• Estate of Gow• Estate of Martin: disallowed multi-tier discounts
www.shenehon.com
18
• In Astleford v. Commissioner, the court concluded that multi-tier discounts areconcluded that multi tier discounts are appropriate when the lower tier interest constitutes a relatively small percent of the
tiupper tier.Ownership interest Discount
Tier 1 Rosemont farmland proeprty 20% absorption discount
Tier 2 50% general partner interest in Pine Bend 30% discount for lack ofTier 2 50% general partner interest in Pine Bend 30% discount for lack of control and marketability
Tier 3 Limited partner interest in AFLP 35% discount for lack of control and marketability63.6% effective combined discount*
*Note: The combined result of the tiered discounts is multiplicative, not additive, Ifthe property had a net asset value of $100, its value inside AFLP was only $36.40[$100 x (1 ‐ 20%) x (1 ‐ 30%) x (1 ‐ 35%)]
www.shenehon.com
19
Critical Points to AddressCritical Points to AddressWhat are some of the significant issues for the appraiser?issues for the appraiser?
• There are several crucial points to address when appraising tiered or layered entities:appraising tiered or layered entities:
– How will the appraiser deal with multiple levels of governance structures?
www.shenehon.com
20
Critical Points to AddressCritical Points to Address– How does the appraiser arrive at appropriate discounts
when there is no market data to support the discounts selected?
– How does the appraiser accurately describe (in the pp y (report) what is actually being valued?
– FMV – uses the same studiesFMV uses the same studies
www.shenehon.com
21
Relevant Practice ConceptsRelevant Practice ConceptsWhat are some of the significant practice concepts?practice concepts?
• If using the net asset value (NAV), determine current net asset value and subtract all liabilitiescurrent net asset value and subtract all liabilities to arrive at net equity. Revenue Ruling 59-60 “suggests” the appraiser place the greatest weight on adjusted net asset value. If using this approach, all assets should be adjusted to the current economic value.
www.shenehon.com
22
Relevant Practice ConceptsRelevant Practice Concepts• Outline the ownership structure as clearly as
possible (CRITICAL)possible (CRITICAL)• Do a clear flow chart • Determine discount for lack of control (DLOC)
and discount for lack of marketability (DLOM) at each entity level
www.shenehon.com
23
Implementation PitfallsImplementation PitfallsWhat are some of the practical implementation issues?implementation issues?
• “When you stretch, or tier, partnerships i l thi h ” (Willi F imiraculous things can happen.” (William Frazier,
ASA, 2004)• Does your result follow common sense?Does your result follow common sense?
www.shenehon.com
24
Implementation PitfallsImplementation Pitfalls• By stacking or layering partnerships, valuable
assets can be rendered virtually worthlessassets can be rendered virtually worthless.
• Markets of today are far more liquid and y qefficient than they were in years past. Partnership Profiles states that, on average, it is 45 days to cashis 45 days to cash.
www.shenehon.com
25
Implementation PitfallsImplementation Pitfalls• How do you avoid the double-counting of
discounts? Understand that at tier one thediscounts? Understand that at tier one, the value is on a liquid cash basis.
www.shenehon.com
26
Alternative ApproachesAlternative ApproachesWhat are some of the alternative approaches to completing this area pp p gof the appraisal assignment, with contrasting risk and benefits?
• The appraiser may elect to use a top-down approach rather than the traditional bottom-up NAV approach The top-down approach looks atNAV approach. The top-down approach looks at discounted yield and time of sale (marketing time) of the lower entity, basically, a discounted cash flow approach
www.shenehon.com
discounted cash flow approach.
27
Alternative ApproachesAlternative Approaches• See Dennis Webb’s “Creating Order Out of
Chaos.”Chaos.• The top-down approach looks at discounted
yield and time of sale (marketing time) of the l tit d t th t l l b i lllower entity, and at the next level, basically, a discounted cash flow approach.
www.shenehon.com
28
Alternative ApproachesAlternative Approaches• The appraiser might also look at dividend yields
with a sell-off in n years.with a sell off in n years.
• Using the top-down approach may help the appraiser avoid double-counting discounts byappraiser avoid double counting discounts by assessing the risks of the cash flows. It may also produce a value that does not make logical sense.
www.shenehon.com
29
Sample Case StudyABC Business Group
(Second Level of Discounts)
JEWEL Partners (Pass Through, No Discounts)
Additi l t i ti d t t hi t t di t ib ti d d bt d i th dditi l di t
XYZ Entity (Non‐controlling Interests in Multiple Underlying Real Estate Holding Entities) (First Level of Discounts‐Traditional)
= Additional restrictions due to agreements, ownership structure, distributions and debt drive the additional discounts
= Limited restrictions (not material enough to require discounts)/Limited, if any, business purpose (pass‐through entity)
= Basic non‐controlling (minority) and lack of marketability discount analysis
www.shenehon.com
30
Exercise - Defining the Assignment
What are we ABC Business Groupare we valuing?The assignment is Name of Business: ABC Business Group
(Second Tier)
The assignment is to value a 30.6% Limited Partnership I t t i ABC
pLocation: 5000 April Way
Anytown, MinnesotaClass of Business: Limited PartnershipDate of Valuation: March 15, 2015O ( ) % H ldi iInterest in ABC
Business GroupOwner(s), % Holdings: VariousAdjusted Book/Market Value: $5,075,611
www.shenehon.com
D fi i th A i t
31
Defining the Assignment
V l i f M h 15 2015 S II L d DiValuation as of March 15, 2015 - Stage II Layered Discount
Asset Approach (NAV): ABC Business Group
100% Fair Market Value of Entity $5,075,611
Subject Limited Partnership Interest 30.613334%
Pro Rata Value Before Discounts $1,553,814L Mi it Di t 10 0% ($155 381)Less: Minority Discount 10.0% ($155,381)
Market Value with Minority Discount $1,398,432Less: Lack of Marketability Discount 5.0% ($69,922)
Fair Market Value of Interest $1 328 511Fair Market Value of Interest $1,328,511Rounded To
$1,329,000
www.shenehon.com
32
Review of Governing DocumentsStage II Discounts
• Ownership Structure• Governance
Stage II Discounts
• Governance– Control– Operating distributions
• Partnership Changes• Debt and Distributions
www.shenehon.com
B l Sh t R i d A l i
33
Balance Sheet Economic Adjustments - AssetsABC Business Group / Jewel Company
Balance Sheet Review and Analysis
Year Historic Adjustment Economic29-Feb-15 15-Mar-15
Current Assets:Cash $95,882 $95,882Investments $535,177 ($143,347) $391,830USA Financial $455,518 ($179,716) $275,802Loan Receivable - Gth Supply $124,755 ($49,902) $74,853Total Current Assets $1,211,332 ($372,965) $838,367
Fixed Assets:Land, Building, Improvements, Equipment $0 $0 $0Other Fixed Assets $0 $0 $0Total $0 $0Less: Depreciation $0 $0 $0Total Less Depreciation $0 $0 $0Total Less Depreciation $0 $0 $0
Other Assets:49% LP INT - JEWEL Partners * $717,237 $5,147,460 $5,864,697Total Other Assets $717,237 $5,147,460 $5,864,697
www.shenehon.com
TOTAL ASSETS $1,928,569 $6,703,064
B l Sh t R i d A l i
34
Balance Sheet Review and AnalysisBalance Sheet Economic Adjustments - Liabilities
ABC Business Group
Year Historic Adjustment Economic2/29/2015 15-Mar-15
Current Liabilities:Current Liabilities $0 $0Total Current Liabilities $0 $0 $0
Other Liabilities:Long-Term Debt $0 $0Total Other Liabilities $0 $0 $0
Total Liabilities $0 $0 $0
Equity:Equity $1,928,569 $4,744,495 $5,075,611Total Equity $1,928,569 $5,075,611
www.shenehon.com
Total Liabilities/Equity $1,928,569 $5,075,611
35
Wh t d XYZ E tit t i ?
First Tier ValuationWhat does XYZ Entity contain?
Ownership in
General Partner Ownership %
Ownership inXYZ Entity
March 15, 2015
Brooke Trout 1.0%Roger Smith 1.0%
Limited Partners Ownership %Sushi Group 49.0%Sus G oup 9.0%ABC Business Group/Jewel 49%
Total 100.0%
www.shenehon.com
36
First Tier Valuation
Historical Distributions - XYZ EntityFYE Dec-12 FYE Dec-13 FYE Dec-14
Distributions $296,000 $319,700 $356,650Net Income $418,320 $364,615 $394,782
Historical Distributions XYZ Entity
Distributions/Net Income 71% 88% 90%Estimated Partner Tax Liability: 40% of NI $167,328 $145,846 $157,913Distributions Excess of Partner Tax Liability $128,672 $173,854 $198,737
www.shenehon.com
B l Sh t R i d A l i
37
Balance Sheet Review and AnalysisYear Historic Adjustment Economic
29-Feb-15 15-Mar-15
XYZ Entity - Flows into Jewel Company
29 Feb 15 15 Mar 15
Current Assets:Cash $198,770 $198,770Total Current Assets $198,770 $0 $198,770
Fixed Assets:Land, Building, Improvements, Equipment $0 $0 $0Other Fixed Assets $0 $0 $0Total $0 $0Less: Depreciation $0 $0 $0Total Less Depreciation $0 $0 $0
Other Assets:(A) 50% INT - Oak House Apartments, LLC $39,428 $644,572 $684,000(B) 50% INT - Seaside Park Apartments, LLC $161,205 $1,064,795 $1,226,000(C) 50% INT - Land Court Apartments, LLC $175,108 $1,686,892 $1,862,000(D) 16.67% INT - Spring Properties $88,259 $1,211,741 $1,300,000
Pro Rata
(E) 50% INT - Fireside Apartments, LLC $155,562 $2,163,438 $2,319,000(F) 25% INT - Wood Estates, LLC $151,174 $1,466,826 $1,618,000(G) 50% INT - Lakeside Apartments, LLC $173,298 $1,699,702 $1,873,000(H) 16.6667% INT - Apple Partners, LLP $311,302 $244,698 $556,000(I) 16.667% INT - Tide Partners, LLP $135,162 $196,838 $332,000
Total Other Assets $1,390,498 $10,379,502 $11,770,000
www.shenehon.com
TOTAL ASSETS $1,589,267 $11,968,770Times: 49% Pro Rata Interest 49%PRO RATA VALUE (BEFORE DISCOUNTS) $5,864,697
B l Sh t R i d A l i
38
Balance Sheet Review and AnalysisSUMMARY AND INDICATED PRO RATA VALUE
Current Assets $198,770
Net Fixed Assets $0
Other Assets $11,770,000
Total Assets $11,968,770
Less: Total Liabilities $(0)
100% adjusted Net Equity $11,968,770
Times: 49% Pro Rata Interest 49%
Pro rata Value (No Discounts Applied) $5,864,697
www.shenehon.com
B l Sh t R i d A l i
39
Balance Sheet Review and AnalysisBalance Sheet Economic Adjustments - Liabilities
XYZ Entity
Year Historic Adjustment Economic2/29/2015 15-Mar-15
Current Liabilities:Current Liabilities $0 $0Total Current Liabilities $0 $0 $0
Other Liabilities:Long-Term Debt $0 $0Total Other Liabilities $0 $0 $0
Total Liabilities $0 $0 $0
Equity:Equity $1,589,267 $10,379,502 $5,684,697Total Equity $1,589,267 $11,968,770
T t l Li biliti /E it $1 589 267 $11 968 770
www.shenehon.com
Total Liabilities/Equity $1,589,267 $11,968,770
40
Balance Sheet Review and Analysis
XYZ Entity - 49% Interest
Equity Before Discounts $5 864 697Equity Before Discounts $5,864,697DLOC 15% ($879,705)
4,934,992$ DLOM 15% ($747,748)
Flows to ABC
Net Value After Discounts 4,237,244$
www.shenehon.com
41
Discount Analysis
In one case pertaining to layered (Second Stage) discounts, Roy O. Martin, Jr. v. Commissioner, 50 T C M 768 (1985) the same discounts for lack ofT.C.M. 768 (1985), the same discounts for lack of control and lack of marketability were applied at both levels, at the direct partial ownership level (first stage) AND at the second-stage level.
www.shenehon.com
42
Discount Analysis
The Court stated clearly that this was incorrect… “we conclude that the second stage 50-percent discounts are mostly duplicative of the 50discounts are mostly duplicative of the 50 percent discounts applied at the level of the underlying corporations and, therefore, they unreasonably reduce the value of Arbor shares.”
www.shenehon.com
43
Why lower discounts at level two?
• Risks and desirability have been substantially reduced at the first level of discounts.
• By definition, the market value of this holding is reduced to cash or cash equivalent.
• Second Tier is further restricted by another set of• Second Tier is further restricted by another set of governance rules (lack of control) and even fewer buyers (lack of marketability).
www.shenehon.com
44
Determining DLOC at Level Two
• Normal studies should be used – majority of Class of Assets were cash equivalent (already discounted)discounted)
• Core closed-end funds are used – most blcomparable
www.shenehon.com
45
Core Closed-End FundsFund Name (Ticker)
Asset Class
Market Return
Prem/ (Disc)Fund Name (Ticker) Class Return (Disc)
Cornerstone Total Return (CRF) Core Funds -1.77% 11.21% Engex Inc (EGX) Core Funds -2.12% -18.14% Advent/Clay Enhcd G & I (LCM) Core Funds -3.36% -21.49% Old Mutual/Claymore L-S (OLA) Core Funds -7.14% -19.72% Liberty All-Star Growth (ASG) Core Funds -8.88% -17.86% Source Capital (SOR) Core Funds -9.09% -14.79%
Second
Cohen & Steers CE Oppty (FOF) Core Funds -10.04% -5.18% Nuveen Core Equity Alpha (JCE) Core Funds -10.72% -15.47% DWS Dreman Val Inc Edge (DHG) Core Funds -11.44% -21.83% SunAmerica Foc Alpha LCp (FGI) Core Funds -11.62% -16.32% Central Securities Corp (CET) Core Funds -11.81% -21.56% Tri-Continental Corp (TY) Core Funds -12.17% -5.77% Blue Chip Value Fund (BLU) Core Funds -13 62% -18 15% Second
TierBlue Chip Value Fund (BLU) Core Funds -13.62% -18.15%S&P 500 GEARED Fund (GRE) Core Funds -13.63% -3.94% Clay/Ray James SB-1 Eqty (RYJ) Core Funds -13.73% -0.65% Adams Express Company (ADX) Core Funds -14.39% -16.91% Zweig Fund (ZF) Core Funds -15.05% -18.77% Boulder Growth & Income (BIF) Core Funds -16.31% -23.23% Royce Micro-Cap Trust (RMT) Core Funds -18.51% -9.13% General Amer Investors (GAM) Core Funds -18.85% -17.86% Royce Value Trust (RVT) Core Funds -20.14% -8.97% Liberty All-Star Equity (USA) Core Funds -20.81% -22.48% Gabelli Div & Inc Tr (GDV) Core Funds -22.40% -16.90% Defined Strategy Fund (DSF) Core Funds -26.97% -4.41% Eagle Capital Growth (GRF) Core Funds -- -14.92%
www.shenehon.com
Average Discount -13.73% Median Discount -14.77%
Inter-Quartile Range -8.97% to -18.77%
46
Lack of Marketability DiscountsR l t F t f L k fRelevant Facts for Lack of
Marketability DiscountsLimited Partner does not control, the General Partner has all control DISCOUNTGeneral Partner has all control DISCOUNT
General Partner determines distribution DISCOUNTGeneral Partner determines distribution DISCOUNT
Assets are on a cash equivalent basis DISCOUNT
Range of Lack of Marketability Discounts 9% to 19%
S l t d L k f M k t bilit Di t 15%
This is down today.
www.shenehon.com
Selected Lack of Marketability Discount 15%
47
Lack of Marketability Discounts
Summary of Results of Restricted Stock Studies
Date of Number of Median Mean Range of DiscountsStudy Study Observations Discount Discount Low High
SEC Institutional Investor Study 1969 398 24% 26% -15% 80%Gelman Study 1968-1970 89 33% 33% less than 15% greater than 40%Moroney Study 1968-1972(approx.) 146 34% 35% -30% 90%Maher Study 1969-1973 34 33% 35% 3% 76%Trout Study 1968-1972 60 N/A 34% N/A N/Aout Study 968 97 60 N/ 3 % N/ N/Stryker/Pittock Study 1978-1982 28 45% N/A 7% 91%Willamette Management Study 1981-1984 33 31% N/A N/A N/ASilber Study 1981-1988 69 N/A 34% -13% 84%Hall/Polacek Study 1969-1992 100+ N/A 23% N/A N/AManagement Planning Study 1980-1996 53 24 8% 26 8% 0% 58%Management Planning Study 1980 1996 53 24.8% 26.8% 0% 58%
www.shenehon.com
48
Lack of Marketability Discounts
• We use MPI-Study discounts for lack of marketability even though it is based on operating companiesoperating companies
• Keep in mind: the asset class is a cash equivalent which reduces the risk
• Based on Gross Income, Earnings, and Earning Stability, the range of DLOM was 14.1% to 21 81% (this has receded as of today)21.81% (this has receded as of today)
• Use Judge Laro’s Ten Points to help quantify DLOM
www.shenehon.com
49
Lack of Marketability Discounts
40%
Lack of Marketability Discount by Asset ClassComparison of risk and Discounts
20%
30%
40%
No DataNo Data
Securities Real Estate Operating Companies0%
10%
Expected Return Low Range LOCDiscount
High Range LOCDiscount
Appraised
www.shenehon.com
50
Measuring Lack of Marketability Discounts for Tier AssetsDiscounts for Tier Assets
• Same studies were used for the operating thi b tt il bl t d tcompany – nothing better available to date.
Note: rates of return are:– 1/3 to 1/2 less than operating studies– 27.5% to 36% = normal rates of return
• Cash equivalents for securities must be used which makes the discounts lowerwhich makes the discounts lower
www.shenehon.com
51
Summary
DISCOUNT SUMMARY
ABC Jewel 49% TotalInterest
DLOC 10% 0% 15% 25%DLOC 10% 0% 15% 25%
DLOM 5% 0% 15% 20%
www.shenehon.com
52
William C. Herber, CBA, CVAWilliam C. Herber, CBA, CVAMr. Herber is senior vice president and shareholder of Shenehon Company and managing director of its business valuation division. Shenehon is a commercial real estate and business valuation firm located in Minneapolis, Minnesota Bill has over 25 years of valuation experience specializing inMinnesota. Bill has over 25 years of valuation experience, specializing in intangible assets, fractional equity interests, holding companies, and special use properties. He is published in both local and national trade journals and has served as an instructor for numerous seminars. He has also testified as an expert witness in federal, state, and district courts, as well as for commission hearings and mediations Mr Herber received his BA incommission hearings and mediations. Mr. Herber received his BA in Accounting from the University of St. Thomas.
Shenehon Company88 S 10th St t S it 40088 S. 10th Street, Suite 400Minneapolis, MinnesotaDirect: 612.333.6533Bherber@shenehon.com
www.shenehon.com
@